Risk Monitor: Time to reset your investment compass?

07-17-2014

Many investors continue to say that they are waiting for a correction before adding to or even getting back into equities. In a recent survey, a fifth of Ned Davis Research clients put the odds of a 20% correction before year-end at 50-50, with nearly half saying the market’s gains for the year are essentially over. The same survey also showed that a majority of the research firm’s clients expect 10-year Treasury yields to stay in the 2.50%-3.00% range the rest of the year. These findings are far more cautionary than they were six months ago, when Ned Davis last surveyed its clients. Yet despite the growing pessimism, the market’s “fear gauge’’—the VIX—continues to hover near its 52-week low.

It is unusual for investors to be relatively calm about the market and sanguine about rates yet worried that a nasty sell-off in equities may be in store. What this tells us is that individual investors continue to have a hard time buying into this bull. According to the Investment Company Institute, domestic equity fund flows that had turned positive last year for the first time in five years have turned sharply negative again and are now down for the year. At the same time, bond flows have reversed course from 2013’s strong second-half outflows, ending this year’s first half significantly higher. In other words, the expected “Great Rotation’’ from bonds to stocks has gone P-f-f-f-t.

This data indicates the damage to equity investor psyches from the dot.com collapse and the Great Recession that bookended the past decade was deep and damaging, though we believe not permanent. The love affair with stocks that rekindled in the early 1980s and flourished through the 1990s ended badly, and if a nearly 200% rise in the S&P 500 from its March 2009 lows hasn’t mended that relationship, it’s not clear what will. This is unfortunate, as history tells us that over time, equities tend to outperform bonds and other assets. Indeed, while Ned Davis Research’s Chief Global Investment Strategist Tim Hayes is among those thinking a quick but deep sell-off is possible this year, he quickly adds that he and the respected research firm believe equities remain very much in a secular bull. We believe anypull back is actually an opportunity to add to equities.

Clearly, long-term investors need a way to feel OK about getting back into or sticking with a certain level of equity exposure. That’s where managed-risk strategies come in. As we’ve said before, these approaches seek to put loss avoidance on equal if not elevated footing in relation to generating excess positive returns. And as we’ve also said before, they aren’t some fancy but fleeting concept as their critics contend, but actually have been around for decades, rooted in the principles of value investing. What these strategies can do is offer, in the words of Nobel laureate and behavioral economist Richard Thaler, a “nudge’’—a way for cautious investors to break the inertial avoidance that has prevented them from participating in what we and many others, including Ned Davis, believe is a secular bull with a lot of room left to run. Might there be pullbacks, even sharp corrections? Undoubtedly. But by defining risk as “loss of capital,” we can manage it and help the skittish investor navigate, even potentially benefit from it. Think of this approach as a GPS system for your portfolio.

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

There is no guarantee that managed-risk strategies will be successful.